People, people, people.

Dec, 2014

People, people, people.

In his Common Stocks and Uncommon Profits, Philip Fisher pointed out that the force that creates “an outstanding investment vehicle…is essentially people.”

Warren Buffett says that one of his main tasks in evaluating a company is to look the management in the eye and see if they are truly passionate about their work.

Peter Lynch points out that he loves managements who love their companies and that pass up the fancy corporate offices for garage-style digs to save money.

Eddie Lampert says he places more emphasis on the people who put together a track record rather than the track record itself.

Still yet, Marty Whitman told me that he’s been fortunate enough to “go to bed with great managements” and will look for the same in future investments.

Catching the trend?

Clearly, one of the most important jobs for investors is to evaluate the management of the companies in which they invest. Managements have the power to create gold mines or destroy castles, and with the way proxy machinery really works in corporate America (with managements typically choosing boards of directors rather than shareholders), it is absolutely essential that the “little guy” know what kind of people he is dealing with.

Not surprisingly, many investors will talk about how much they care about evaluating managements or how good they are at picking up talent. And who can blame them? No one would admit that they haven’t really looked at the people behind the scenes. No one would admit that they are simply not good at picking out talent and weeding out incompetence. And further still, no one thinks they are not a “people person” who can read others like a book.

But few – I argue very few – actually walk the walk. They think they know the management and how great (or bad) it is, but they’re often mistaken. Yet, one cannot really blame them for this. As the huge majority of investors are outside, passive, minority holders, getting access to management is not the easiest thing and often makes little sense given the size of the investment. So what is the average investor to do?

I propose a few easy steps to gain insight into the passion, competence, and shareholder friendliness of the people behind your investments. These are steps that any investor can take by making use of public documents, the written word, and some common sense. Some you’ve probably thought of or heard of before, but I hope you gain something from at least a few of them.

Check the salaries. Managements of publicly traded companies must disclose their salaries in 10-K’s filed with the SEC. Take note of how generously the management is paid. Naturally, smaller companies should have managements that are paid less (a $20 million company shouldn’t have a CEO getting paid $1 million+). Larger companies generally display the reverse. But overall, the most important thing is to determine whether management deserves those salaries. Just because a company is large or has “potential” does not mean management has truly earned its paycheck. How long has top management been with the company? How well have they used shareholder money to gain high returns?

Check the bonuses. Beware of managements that are awarded generous stock options, pension plans, perks, etc. This information is also disclosed in public documents, and you can easily find how many stock options management has been granted, what the exercise price and date of those options are, etc. The general theory behind options are that they align interest with the shareholders by giving management incentive to perform well for more pay. But keep this in mind – generous options packages can promote risky behavior since there exists unlimited upside and little to no downside for management if things fail. Also, more commonly, they can lead to practices that lift share price without creating real value (unnecessarily high dividends, unnecessary share buybacks, practices that show more earnings even though more tax effective methods are available, or, at its extreme worst, fraud). In short, be generally wary of managements that are willing to waste or dilute shareholder value to stuff their own pockets.

Check the ownership. I prefer managements that have heavy ownership in the company and a large fraction of their net worth tied up in the company. It shows that they will have a greater tendency to think and act like you as an investor. I’m suspicious when I see executives sell-off a ton of shares, and I like to see when executives are putting their money where their work is and buying shares on the open market.

Listen to conference calls. It’s probably the best way small shareholders have to get acquainted with management and hear them talk about the company, its goals, its attitudes, its triumphs and failures. Most importantly, focus on their discussion of the failures. The most honest and competent management will have no shame in and will not try to hide their mistakes. When management comes forward and says “we did this wrong, we need to improve here,” you can generally bet that your dealing with honest and competent people. When you hear them always blaming circumstances, customers, or other people, proceed with extreme caution. [Note: A great resource for analyzing conference calls can be found atSeeking Alpha, where transcripts are available free of charge]

Note the tone in the 10-K section dedicated to Management’s Discussion and Analysis. This is similar to listening to conference calls – how does management discuss its failures and shortcomings? Are they confident? Over-confident? Honest? Suspicious? This is generally tougher since the section is obviously written before hand (unlike a conference call) and remains largely objective, but you can always be on the lookout for warning signs.

Pay attention to the employeesand rankings. I love to read Fortune’s list of the best places to work. When a company treats its employees with dignity and respect and pays them well for their hard work, I become a bigger fan of the company as an investment. Companies that make great places to work are usually so because people from the top have made it that way. I believe that, in general, a company that treats its employees well will be more likely to treat its shareholders well. Not to mention the improved productivity of the workforce whose hard work makes owners money.

Pay attention to customers. Managements that stress superior customer service are people-conscious, and, as with #6, usually shareholder conscious. If customers complain about a company’s inferior service, nasty employees, and terrible value, you can bet on an inferior stock, with nasty management, and, well, terrible value.

Fib a bit. If you have the guts and time, do what Peter Lynch recommends – fib a bit, call the company, tell them you hold a bunch of shares in street name, and that you wish to speak with management. While doing so, remember this: a company that refuses to talk with you, the “big shareholder,” is not worthy of investment for obvious reasons. And, if they do speak with you, make the most of it and ask away. Pepper them with questions and try to get a feel for their abilities.

Trust your gut. If you have a sneaking suspicion that the CEO of the company you’re researching is some slick fast-talker who’s just looking for a quick buck, do yourself a favor and don’t invest. Even if you’re wrong, there are no called strikes in investing and you save yourself the headache.

There are clearly plenty more great ways to get to understand management, but I believe these are nine useful and generally easy ways to get to know the people behind your investments, even if you’re not a big shareholder. In short, look for passion, honesty, aligned interest, and people-consciousness. As Warren Buffett says, it’s simple, but not easy. Hopefully I’ve made is a bit easier.